Stock trades, donations and retirement contributions can have surprising effects on your taxes. Here's how to use tax software to determine whether it will pay to pull the trigger.
Some of these schemes are, or should be, familiar, such as harvesting tax losses in your portfolio. Some are less so, such as choosing Roth for a last-minute contribution to a self-employed retirement plan. All have the potential for creating surprises.
Surprises? Selling a depreciated stock might make your college tax credit go up. Sticking with pretax retirement contributions over the aftertax (Roth) kind might damage the 20% pass-through deduction for the self-employed. A Roth conversion could easily make your dividend taxes go up. Any of these things can produce weird effects on your foreign tax credit.
For such surprises you can thank the convoluted ways in which different tax rules are connected. Instead of a flat tax, Congress has created a system of benefits and phase-outs, credits and surtaxes, goodies and grab-backs, all wrapped around rewards for favored behavior or favored constituencies. Unspoken platform element of both political parties: “Let’s curry votes by making the tax code more complicated.”
Don’t throw up your hands. Do this instead: Buy software. Buy it now, not in February when you were going to start work on your taxes. It won’t cost more to buy early. Updates, which stream in constantly during the tax season, are free.
#1. Portfolio sales
You may already have gains or losses in your base case, Dummy 1. Dummy 2 incorporates the transaction you’re thinking about adding now. (We are, of course, talking about your taxable brokerage account; changes inside an IRA are irrelevant.) It will probably make sense to harvest any capital losses that remain unrealized.
#2. Conversions
Aftertax (that is, Roth) IRAs are more valuable than pretax IRAs. It often makes sense to convert some of the latter to the former by prepaying income tax on the converted amount. But you should never do this without first getting a price tag on the conversion.
Isn’t the price determined by your tax bracket? No, it’s nothing so simple. You might be in a 24% federal bracket (taxable income between $201,051 and $383,900 on a joint return), but converting $10,000 won’t necessarily cost you just $2,400 in federal taxes. It might run you $2,780. Why? Because it pushes more of your investment income into range of the 3.8% investment income surtax.
There’s no telling what will happen by looking at a bracket table. Find out by comparing Dummy 1, without the conversion, to Dummy 2, with it.
#3. Bunching
The standard deduction for a young couple is $29,200, which means that itemized deductions totaling less than that amount do no good. Consider putting several years of giving into one year by contributing to a donor-advised fund, then disbursing the money over time. This might make sense if the total donation, with other itemized deductions, puts you well above the standard deduction. It especially makes sense if you use long-held appreciated securities for the donation, since the deduction is figured on their current value, with the appreciation never taxed.
Wealth advisors often recommend combining a charity bunch-up with a Roth conversion. Test different amounts. Keep a close eye on the results. You might not know, but the software will know, that the deduction from appreciated securities is capped at 30% of adjusted gross income.
If you are a regular user of tax software you can speed up the dummy return process by opening your 2023 program, saving a copy of your 2023 return and messing with that copy. For Dummy 1, raise a few key entries (such as one of the W-2s, one of the dividend 1099s and one of the Social Security amounts) so that the income total reflects inflation. Save a copy as Dummy 2 and put your Roth conversion or whatever on that. The bracket boundaries will be a bit obsolete, but the Dummy 2 versus Dummy 1 differential will probably be close to the truth.
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